Beware this Profit Reduction Strategy

Is selling half a good idea?

Think about this for a moment. Your answer could have a big impact on your results.

Many people like to sell half of a profitable trade. They say it’s better to bank some profit early than risk a lower price later. As the saying goes, ‘You never go broke taking a profit.

But what if prices keep rising?

I know a bit about this strategy. You see, I’ve used it a lot over the years. I’ve also seen many colleagues scaling out of positions. If popularity is any guide, then selling half is a winner.

Now, I’ve tried many variations of this tactic. Some were better than others. But there was one I liked best — maybe you’ve tried it yourself. This is how it went…

I’d sell half when my profits were equal to my initial risk. This would mean, that overall, my worst possible result was breakeven. I reasoned this was like getting a free trade.

But the strategy had a weakness…

You see, I was halving the size of my best trades. Meanwhile, my losing trades were running at full strength. This meant my winners had to work harder to cover the losses.

The reality was this: I had to get more out of my profitable trades. Selling half was holding me back — it was effectively a profit reduction strategy.

I’m going to show you some research in a moment. You’ll be able to decide the merits of selling half for yourself.

But first, here’s a reminder of what lead to this topic…

The short answer

Last week I wrote about Quant Trader’s exit stops (you can review the article here). The inspiration for the report was a member’s email. Here’s an excerpt of what he said:

I’m a new subscriber to your service. I’ve begun by testing the outcomes we have attained on some stocks we’ve held (and sold too early) in comparison with your signals on those same stocks. We were impressed; had we bought on your signal 1, and not sold when we did, we would have been much better off.

Do you always rely on hitting the exit-stop before selling? Or do you lock in a partial profit by selling half a holding? (Taking profits has been an important strategy for us.)

Member, Richard

The short answer to Richard’s question is, no, Quant Trader doesn’t sell half.

I often talk about the importance of cutting losses. This is one of the most fundamental rules of trading. People who ignore this often quickly lose their money.

But there’s a rule that I believe is of equal importance…

As well as limiting losses, you need to un-limit your gains.

Quant Trader doesn’t have a cap on profits. The system holds a stock until the exit stop is hit. Letting profitable trades run is a key part of the strategy.

So, just how important is running winners?

Let’s look at that now.

Would you pay the price?

There are two ways to test a strategy. You can use trial and error — like I did when I began my career — or you can use back-testing.

The worst part of trial and error is that it takes lots of time. There’s also a risk that current trading conditions bias your results. This could lead you to false conclusions.

Back-testing gets around both these issues. You can learn more in one afternoon than in a few years of live trading. All you need is a computer and lots of data.

So, here’s what I did: I designed a simulation to test which strategy makes more money — selling half, or holding the whole position until the exit stop is hit.

The first scenario uses Quant Trader’s entry and exit strategies. The only change is there’s no 100 company cap. This ensures each simulation has the same portfolio.

Scenario two is almost identical. The only difference is that it sells half once a stock rises by 25%. The remaining shares stay in the portfolio until the exit stop triggers.

Now, there are many points you could sell half. I chose 25% because this is where profits equal Quant Trader’s the initial risk. Many traders use a similar strategy (I once did this myself).

OK, what do you think you’re going to see?

Take a moment. I want you to think about what’s going to happen, and why. This is a fun way to test your trading logic.

Right, here are the results:

Quant Trader Graph - Hold vs Sell 2017

[Click to enlarge]

Now let me explain what’s going on.

The simulation is for the past five years. It uses $1,000 for each long trade (the system only trades signal 1s). As always, there’s no allowance for costs or dividends.

You’ll see there’s a high correlation between the strategies — they both work. But the one depicted by the blue line is gradually pulling away. It has an edge on its cousin.

Are you able to identify the blue strategy?

I’m sure you can. It’s the one that keeps the entire position. There is no selling half.

I’ve got another chart for you. It plots the margin between holding the lot and selling half.

Have a look at this:

Quant Trader Graph 2017 - Price of Selling Half

[Click to enlarge]

Resisting the urge to sell half is more profitable. The average winning trade was 36.3%, verse 29.4% for the sell half strategy. Exiting early can prove expensive over time.

As a rule of thumb, profitability increases as the threshold for selling rises. For example, selling half at 50%, instead of 25%, will generally give a better overall result.

But this doesn’t mean you should never partially sell a profitable trade. It all depends on what you’re trying to achieve. Selling half may be the right strategy for some people.

An advantage of selling half is that it can reduce volatility.

You see, as a stock rises, it’s weighting in your portfolio typically increases. This makes the portfolio more sensitive to its price changes. Scaling back a profitable trade reduces this sensitivity.

Personally, I prefer to let all my profits run. I believe this is pure trend following. But if you want to take some profits after a big run, that’s OK too.

I don’t like to solely use a fixed percentage — like 25% — to sell half. A stock could be powering higher and you sell just because it hits a certain level. That just doesn’t stack up in my view.

If you do sell half, I believe it’s better to combine a target with an indicator. For example, sell half if a profitable trade is losing momentum. This helps avoid an early sale while the trend is strong.

We all like to bank a profit. It makes us feel like we’re getting ahead. But be careful not to sell too soon. Early exits can greatly limit the profits of your best trades.

Until next week,

Jason McIntosh,
Editor, Quant Trader

Editor’s note: Making money in the stock market is hard. Your job will be even tougher if you’re regularly selling your best stocks. People who are quick to take profits rarely get big triple digit gains.

But it doesn’t have to be this way…

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All charts are sourced by Quant Trader.

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